First, let's start with a comparison of mutual funds and ETFs. Mutual funds are pooled investments managed by a mutual fund company with a certain objective in mind. They can be set up to follow an index or they can be actively managed by a manager or management team. Many investors do not realize this, but mutual funds don't actually trade on the market. In other words, they cannot be bought and sold on an exchange. They are actually bought and sold from the mutual fund company directly.
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ETFs are also a pooled investment developed by an investment company, but they trade on an exchange. As a matter of fact, it can be broken up and sold as individual investments at the end of its life or when the investment company chooses to end its life. The investments in the pool often represent an index, although nowadays they are being formed around many combinations of investments.
Why is it important that an ETF trades directly on the exchange? Think of it this way: Let's say you purchase a mutual fund, hold it for a year, and it increases in value. You have likely paid most of the taxes on the gain already. On the other hand, when you buy an ETF and hold it and it has the same gain, you usually have not paid any tax yet.
That's because mutual funds are what we call sub-M corporations and as such transactions much be handled in a certain way. For example, when Stock A is sold, the proceeds go to cash and then that money may be deployed to purchase Stock B. Because the money went to cash, which is a mutual fund requirement, it creates a taxable event.
When an ETF sells Stock A and purchases Stock B, it handles the transaction as if it were a "like kind exchange," which does not create a taxable event. So in essence, the tax treatment is handled identically to buying and selling an individual stock, which is very efficient.
The nice thing about an ETF transaction is that it usually happens as soon as the order is put in. With a mutual fund, if you put in a trade at 10:00 a.m., it does not trade until after the market closes. Mutual funds trade at the closing price of the day of the trade, which could be much higher or much lower than at the time you entered or called in the trade. Again, this can make mutual fund investing less efficient.
Another positive for ETFs is that they usually have a very low internal expense ratio. Depending on the fund and the objective, a mutual fund could cost you 1 or 2 percent higher than the cost of the ETF. And since that is the internal expense, that is charged annually.
So what is the con for an ETF? Most of them are passively managed, meaning they follow an index and do not have a manager per se. But sometimes, active management is needed to outperform the markets. Usually the best way to do this is to find a successful mutual fund manager that has consistently beaten the market and add the fund to your portfolio.
Sometimes mutual funds are better and sometimes ETFs are better. Often it's a good idea to have a combination of both, but do your research before you make that decision.
Good luck and happy investing.
Kelly Campbell , CFP® and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Alexandria, Va. Campbell is also the author of Fire Your Broker , a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.